Fitch questions LBO credit trends

Fitch Ratings says the risk profile of European leveraged transactions has increased, following a record year for leveraged buy-out (LBO) issuance in 2004. While investor demand for assets remains at such high levels, Fitch expects the combination of very high and ever increasing financial leverage and extremely tight pricing to continue.

In a special report entitled “Is this sustainable in 2005?”, Fitch reveals the full year average total leverage ratio for Fitch-rated LBOs exceeded 5.0x for the first time since 2000. It highlights the intense competition among arranging banks, which saw the aggressive structuring of transactions become even more pronounced in H204. Despite this, transactions were syndicated successfully and were frequently oversubscribed. Assets were recycled from their first incarnation into a recapitalisation or secondary buyout transaction with much higher leverage ratios the second time round.

Much of this is attributable to the huge amount of liquidity that flowed into the market in 2004. While Fitch recognises that some of this capital is likely to represent a long-term commitment to the market, it is debateable to what extent some of the inflows reflect liquidity that is short-term in nature.

The agency asks what it will take for a deal to be rejected by investors in the current climate of huge demand, increasing risk and falling reward. Fitch believes it may require a high profile default or evidence that a number of 2004 deals have got into difficulties very early on for the market to cool down.

The LBO market produced a record new issuance of €38.2bn in 2004, up 9% from the 2003 total of €34.7bn. The actual number of transactions increased markedly to 151 from 109. The demand for junior debt paper was enormous. Last year also showed mezzanine and high yield bonds can co-exist and was a record year for both asset classes.